(Abhishek Akshantala, Final Year Student at Jindal Global Law School)
On 19 August 2024, the Securities and Exchange Board of India (SEBI), issued a circular (SEBI Circular) titled ‘Guidelines for Borrowing by Category I and II Alternative Investment Funds (AIFs)’. The SEBI Circular permits conditional borrowing by AIFs. The Circular (in paragraphs A(2) and (3)) overhauls the existing restraints on AIF borrowing under regulations 16(1)(C) and 17(C) of SEBI’s (AIF) Regulations, 2012, namely:
Exclusive use-of-borrowings for temporary funding and day-to-day operational expenses (due within 30 days from the date of an AIF’s borrowing),
Maximum authorized borrowing-frequency of 4 times a year,
An upper borrowing limit of 10% of an AIF’s investable funds.
The SEBI Circular further permits ‘use-of-borrowed proceeds’ by AIFs (subject to the conditions precedent in paragraph A(4)) for advancing covenanted investment principals, in case of the inability of an AIF’s existing investors to match ‘Drawdown Amounts’ (as called from them, to fulfil obligations owed to prospective investee’s), triggering shortfalls (paragraph A(3)).
The Ministry of Finance’s greenlighting of potential Variable Capital Company (VCC) structures for ‘Pooled Private Equity Funds’ in the Union Budget 2024-25, parallelly evidences phased Indian AIF de-regulation.
In this piece, the author attempts to benchmark the antecedent Singaporean and Mauritian AIF frameworks, due to their status as globally-standardized ‘Gateway Jurisdictions’ for Asia and East Africa bound off-shore sponsorship; prove and comparatively analyse India’s ‘Half-Way Harmonization’ (specific to borrowing conditions and VCC mandates); and lastly, argue in favour of AIF debt-regulatory-reconciliation, taking advantage of SEBI’s ‘Consultation Paper on Expanding the Scope of Sustainable Finance Frameworks in the Indian Securities Market’, proposing a normative policy for optimal AIF Environmental Social and Governance (ESG) policy integration.
Restrictions on AIF Borrowing
In Singapore
Singaporean AIFs lack statutory qualitative/quantitative borrowing restraints. They may, however, be bound by investor and creditor discretion through:
Internal Fund document - pre-requisite borrowing allowances (codified by the Private Placement Memorandum (PPM));
Contractual debt terms (mutually effected by the AIF with their creditors).
Additionally, Singaporean AIFs are bound by form-specific regulation. They are conventionally structured as Private Limited Companies (through the Companies Act, 1967), Limited Partnerships (through the Limited Partnership Act, 2008), Unit Trusts (through tailored private trust deeds) and VCCs (through the Variable Capital Companies Act, 2018). There is no generic ‘approval route’ for AIF financing beyond a mandated ‘Written Notice’ submitted to the Monetary Authority of Singapore (MAS), prior to fund offering to investors, under section 305(3)(c)(ii) of the Securities and Futures Act, 2001; and licenses for Capital Markets Services, Licensed Fund Management Companies and Registered Fund Management Companies (awarded by the MAS).
In Mauritius
Mauritian Funds are either ‘Closed-End’ or ‘Collective Investment Schemes (CISs), as per section 2 of the Securities Act 2005 (SA) and the Securities (Collective Investment Schemes and Closed-End Funds) Regulations 2008 (2008 Regulations). Conventionally, AIFs assumed the form of VCCs and CISs.
Regulations 78(a) and 80 define an Expert Fund as a CIS available solely to ‘Expert Investors’ who invest a minimum capital of USD 100,000 or ‘Sophisticated Investors’ (defined in section 2 of the SA and regulation 75 of the 2008 Regulations, as Mauritian/Foreign Government Affiliates, Banks, CIS Managers, Insurers, Investment Advisers, Dealers and Financial Services Commission (FSC) declared persons).
Professional Funds, also being a CIS subset, require exclusive offering of securities to such ‘Sophisticated Investors’ through ‘Private Placement’.
Borrowing by Mauritian CISs is governed by regulations 66(1)(i) and 67 of the 2008 Regulations, generally prohibiting debt and CIS asset encumbrance, however, exceptionally allowing borrowing for the redemption of securities of CISs (parallel to the liquidation of CIS assets) within the limit of 5% of a CIS’s net assets (at market valuation during time of borrowing).
Additionally, the use of encumbrances to finance dues owed to custodians/sub-custodians is permitted. Regulation 67 of the 2008 Regulations ultimately permits the Mauritian AIF Regulator - the FSC’s ‘discretionary waiver’ of regulation 66(1)(i) borrowing restraints, vitiating the blanket-mandatory stature of any borrowing restraints.
Indian Harmonization
Paragraph A(4) of the SEBI Circular introduces the following mandatory conditions for allowing Category I and II AIF borrowing to deter Drawdown Amount scarcity:
Prior disclosure in the PPM by the AIF to investors, of potential willingness to borrow for Drawdown Amount scarcity prevention;
The emergency and last resort nature of the borrowing, without which the AIF’s investment opportunity would be lost (due to definite/in-definite delay by investors in fulfilling Drawdown obligations);
Quantitative restraints:
A limit of up to 20% of the investment being made in the investee (subject to requisite Drawdown fulfilment); or
A limit of up to 10% of the AIF’s investable funds; or
A limit of up to 10% of the commitment pending from investors (actually fulfilling the Drawdown requisite and devoid of indefinite default).
The interest on such borrowings, being paid by the delaying/defaulting investors.
Preventing the result of different Drawdown timelines for AIF investors, due to the permitted emergency borrowings.
Continuous disclosure of every borrowing obtained and repaid by an AIF to its investors.
Compliance with a 30-day period in between 2 borrowings during which no new borrowings can be obtained by an AIF.
In essence, debt-finance for Indian AIFs is restrained with quantitative and qualitative (i.e., use-of-proceeds) limits. Singapore embodies the ‘Party Autonomy’ approach with creditor and investor authority over potential AIF borrowing conditions, while Mauritius captures the ‘Regulatory Prudence’ approach with the FSC’s discretion over AIF borrowing terms-waiver, as per regulation 67 of the 2008 Regulations [exempting regulation 66(1)(i) compliance]. The nascent Indian AIF debt regulation, is hence regressive in comparison to the moderate Mauritian FSC’s discretion and the laissez-faire Singaporean borrowing approval.
While the SEBI circular is step one, the author proposes allowing AIF debt-finance without prescribed use-of-proceeds and exclusive Drawdown specific quantitative-limits and obligations. Further, empowering AIFs with a range of debt-finance options (beyond sole-borrowings; inclusive of Green Debt, Social Bonds, Sustainable Bonds, Sustainability-Linked Bonds (termed as ESG Securities) and Sustainable Securitized Debt Instruments, aligned with paragraphs 3.1 and 4 of SEBI’s Sustainable Finance Framework Consultation Paper, 2024), would align India’s AIF debt-finance framework with global standards and bolster the development of sustainable finance, thereby offering AIFs greater flexibility and competitiveness in the international market.
The immense capital-channelling potential of AIFs in developing the ‘Climate Finance Taxonomy’— deterring climate risk, as idealized by the Finance Ministry’s Union Budget 2024-25 (paragraph 104), can be realized by enabling the access of AIFs to sustainable debt-finance options. The down-streaming of affirmative/restrictive operational and financial covenants - requiring environmentally sustainable and optimal corporate governance/conduct would advance party autonomy and prevent regulatory-arbitrariness.
Such a framework would embody two-tiered self-regulation. First, with creditor-imposed-covenants on AIF’s raising sustainable finance; and second, AIF imposed operational covenants on ultimate investees.
The SEBI can hence mandate a base template of obligations in any debt finance arrangement entered into by an AIF (i.e., ESG compliance of pooled capital channelling), which the parties to the arrangement, can add further terms to (i.e., earmarking of proceeds for investment in specific forms of renewable energy infrastructure).
Ultimately, any expanded debt-finance framework for AIFs, would require preserving the disclosure requisites of the SEBI circular, specifically mentioning the AIFs intention to borrow (with express and exhaustive anticipation of availing potential debt finance options) in the PPM, and providing updated information to every investor regarding the terms of debt; interest and repayment (due dates and ‘earmarking’ conditions).
Prospective VCC Harmonization
Relative to ‘conditional borrowing by Category I and II AIFs’, the proposed Indian VCC scheme was a ministerial policy promise. The Union Budget 2024-25 proposed a ‘VCC Structure’ for optimized financing of aircraft/ship leasing and private equity fund pooling in the Indian jurisdiction (paragraph 105).
The Indian VCC, if harmonized with the antecedent Singaporean and Mauritian VCCs, can overhaul the existing requirement of sole internal-accrual/profit reliance for shareholder dividend declaration and payment by any company as per section 123(1) of the (Indian) Companies Act, 2013. A harmonized VCC structure, would exceptionally permit the payment of dividends out of capital and distributable profit (if anticipated by the VCC’s constitutional documents) aligned with section 34(4) of the Singaporean VCC Act, 2018 and section 20(2) of the Mauritian VCC Act, 2022 which prescribes ‘SPV/Sub-fund specific assets/liabilities’ as the allowed dividend payment source.
As a result, a standardized Indian VCC can provide Private Equity investors with guaranteed returns, irrespective of investment profitability, due to the multiple sources of dividend financing, that such a structure would allow. The risk of loss in Indian investments would significantly reduce, ideally triggering a Private Equity investment boom.
Conclusion
Ultimately, awarding equivalent protections and liberties to investors, through the Indian AIF and prospective VCC regulatory regime, can prevent off-shore regulatory-arbitrage. Harmonization and successive sustainable debt-finance framework creation for AIFs has the potential to effect systemic ESG integration (through ‘Proceed Earmarking’ and ‘Investment Performance Expectations’ influencing ultimate investees, as per paragraphs 2.6.1 and 2.6.2 of the SEBI Consultation Paper).
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